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By Stanley Fischer

Stanley Fischer, vice chairman of Citigroup, USA, was first deputy managing director of the International Monetary Fund until January 2002.

-- As we move into the second quarter of 2002, it is possible to paint a benign picture of the world economy. The U.S. locomotive is regaining speed, Europe is not far behind, pulling the rest of the world to recovery, and good policies are taking hold in important emerging market countries such as China and Russia.

However, a more-or-less synchronized global upswing cannot be taken for granted. There are also real risks to the global outlook. There could be a jolt to U.S. confidence, caused, for example, by another large-scale terrorist act or the still-unfolding implications of the Enron scandal. Secondly, Japan could move from chronic underperformance to a deeper crisis. And there are multiple sources of tension outside Europe and the United States, not least in the Middle East and the Indian subcontinent. Any of these could escalate into both political and economic disruption.


With positive, albeit modest, growth already reported by the Commerce Department in the fourth quarter of last year, the U.S. recovery, bolstered by consumer and business confidence, appears already under way. Much speculation concerns the shape of the recovery. Aggressive monetary easing, an expansionary fiscal policy and a rebound in the inventory cycle all suggest a ''U-shaped'' return to growth or, more accurately, a ''Nike swoosh'' -- mild recession followed by a prolonged but gradual rebound.

Beyond the immediate questions about the U.S. recovery lies the critical issue of the prospects for U.S. productivity growth and thus for the medium-term growth of the economy and of profits -- crucial for stock market performance. On this point, there seems to be a reasonable consensus: We should not expect the truly remarkable performance of the late 1990s to be sustained, but the still unexploited gains of the IT revolution ensure that productivity growth will not return to the dismal rates experienced before 1995. Productivity growth of 2-2.5 percent a year may be attainable.

Another issue is just how far the U.S. current account deficit can rise. Can the United States continue to accumulate foreign indebtedness at its present rate? Certainly there are limits in the long run, but the U.S. external debt, at less than 25 percent of GDP, is not yet in the danger zone unless the rest of the world collectively decides not to invest so much in the United States in the future.

A factor that hovers in the minds of those who worry about the size of the current account deficit is that it is not appropriate for the richest economy in the world to be attracting capital from the rest of the world, where development needs are so much more pressing.

In part, this reflects concern that the U.S. national saving rate is too low. Over the medium term, it would be useful for the United States to save more. Surely, a government budget surplus would contribute to increasing U.S. national saving. But, so long as global aggregate demand remains weak, increasing U.S. saving would slow the recovery. Nor should we forget that capital flows respond to market incentives and that capital will go where the returns are attractive and property rights secure -- in other words, countries that want to develop need to create a good investment climate, not only to attract foreign capital, but even more in order to encourage their own citizens to invest domestically.

In thinking about the current account deficit, we should bear in mind the economist Herbert Stein's reminder: ''If something cannot go on forever, it will stop.'' The question is how it will stop. If foreign investors lose confidence in investing in the United States, the dollar will weaken, and the current account will gradually begin to decline. Provided the loss of confidence is not catastrophic, the adjustment could take place without significant disruption. Or, if other countries grow faster than the United States, the current account deficit can begin to shrink without the dollar declining. So, it is entirely possible that the U.S. current account deficit could increase as the United States leads the global economy out of recession and then begins to decline as growth in other countries recovers.

Growth in the euro area has been sluggish, following the slowdown that got under way last spring. Germany has been affected the worst, with growth also slowing significantly in France and Italy. But there are now signs that business and consumer confidence is bottoming out. This suggests Europe should begin to pick up not long after the U.S. rebounds.

But policy will have to be supportive. German businessmen note, for example, that a cautious European Central Bank (ECB) and constraints on fiscal policy from the stability and growth pact were restraining what might otherwise be more aggressive counter-cyclical policies.

The real problem is not the pact itself but the failure to strengthen fiscal policy and move closer to a budget balance during the good years of growth. If German fiscal policy had been able to start out from a budget balance in 2000, there would have been ample room for a larger counter-cyclical increase in the deficit in 2001 and 2002.

Given these constraints, structural reform, they say, will be more important than ever in securing stronger growth. Without more far-reaching reforms of labor, capital and product markets to boost productivity and lower unemployment, Europe seems destined once again to hit a growth ceiling soon after recovery begins.


Whatever macroeconomic and structural policy challenges confront Europe, they pale in comparison to those facing Japan. Last year saw the country in deflation and suffering its third recession in the space of a decade. Unemployment is still rising, industrial weakness continues, and consumer spending remains depressed. Japan's enduring malaise reflects its failure to deal decisively with non-performing loans in the banking system and a highly indebted corporate sector, both of which are legacies of the bursting of its asset bubble at the beginning of the 1990s.

Japan's key challenges are to counteract deflation and to accelerate structural reform. There is little scope for more expansionary macroeconomic policies. The large budget deficit and government debt preclude fiscal expansion. With interest rates already near zero, the room for maneuver on monetary policy is limited. A more expansionary monetary policy would further weaken the yen and cause grave concern among Japan's trading partners and competitors in Asia and elsewhere. While the yen could weaken a bit more, the concerns of Japan's neighbors and the rest of the world are likely to limit its decline.

With little macroeconomic policy flexibility, and after a decade of dismal economic performance, Japan needs to grasp the nettle of structural reform if growth is to return in the medium term. Non-performing loans will have to be tackled with greater vigor, especially with removal of blanket deposit guarantees.

The government will need to help systemically important institutions, under strict conditionality. More also needs to be done to deal with highly indebted corporations, for example by ensuring that the Resolution and Collection Corporation effectively promotes debt workouts and meaningful operational restructuring.

This is what Prime Minister Junichiro Koizumi was expected to do when he took office. But the political economy of structural reform is difficult, for in the short term more vigorous structural reforms are likely to reduce growth. Hence the tendency of the government to wait, in the hope that things cannot get worse and may well get better.

After all, the Japanese economy has not collapsed in the past decade. Rather, it has suffered from chronic and progressive underperformance. But the economy can get worse. Indeed, there is the possibility of a far more serious recession, with declining confidence in recovery sapping the remaining strength of the banking system, leading to another downgrading of Japanese government bonds and higher bond spreads. This, in turn, would further damage the financial system and fiscal sustainability, and could risk turning into an unstable downward spiral, with the yen weakening throughout the process.

That would, of course, be bad for Japan, bad also for the global economy, and for Japan's neighbors. For all those reasons Japan must take action on its structural problems now to prevent the real possibility of a worse crisis.


The plight of Argentina has everyone's attention. Fortunately, the balance in Argentina has been moving away from populism toward more orthodox policies such as those that served Mexico and Brazil well following their devaluations. But the situation in Argentina is even more difficult than that confronted in Mexico in 1995 and Brazil in 1998, not least because Argentina has defaulted on its debts.

Nonetheless, capital flows to other emerging market countries have recovered much more rapidly than seemed likely in the wake of Sept. 11. Emerging market bond issuance reached near record levels in November 2001 and has remained healthy since. This reflects in large part the abundance of liquidity in the industrialized country markets, but also, as spreads for well-performing countries have declined and the correlation among spreads has fallen, greater discrimination among countries by investors.

The pace of recovery in Latin America this year depends on the strength of the global recovery, on access to international capital markets and on domestic policies.

In emerging Asia, too, prospects in the short to medium term depend to a considerable degree on outside factors -- not only global growth, but also what happens in Japan and to the yen, and on the recovery of the electronics sector. Any significant weakening of the yen would probably lead to depreciations of the flexible exchange rate currencies in the ASEAN countries and Korea.

Fortunately, current accounts are likely to remain in surplus in most countries there. With reserves healthy in most
cases, this means less vulnerability to external financing. Korea, Singapore and Malaysia all look set to pick up speed this year. Thailand is being held back by weaknesses in its financial and corporate sectors. And Indonesia has been hit by a fall in consumer confidence and foreign direct investment, after robust consumer spending insulated overall growth from the effect of weaker business investment last year.

As ever, China's prospects are promising as it continues on its way to becoming one of the world's main manufacturing hubs and eventually one of the largest markets for goods and services. But the authorities face enormous challenges, including a mountain of non-performing loans in state-owned banks and the likelihood that millions of people will be displaced from their current jobs in the restructuring of the economy. Their success in tackling these and other challenges could have profound implications for the global economy in coming decades.

China's entry into the World Trade Organization is likely to spur positive reforms. Japanese conglomerates are already stepping up their investment in the country. And China will have to find a way to develop healthy and efficient financial markets in order to take advantage of some $900 billion in domestic savings and the new stock market culture taking hold among millions of people opening investment accounts.

As a WTO member, however, China will have to ensure that its courts swiftly and fairly apply rules to protect foreign investors' rights, including their intellectual property. It also had to eliminate agricultural subsidies and lower tariffs. All this promises huge, though ultimately beneficial, disruption.

China's bright prospects have prompted some to fear that its dynamism might sap the strength of surrounding economies.

Economists brought up on the theory of comparative advantage do not find this logic compelling, although they recognize that the remarkable pace of change in China could create temporary disruptions. Others have pointed out that China's economic advancement would also create a middle class with a growing demand for foreign goods and services. Indeed, a free trade agreement between China and the ASEAN countries could create the biggest economic area in the world within the next decade, as well as a new Asian community.

Despite impressive growth over the past decade, the fitful pace of reform in India, its large budget deficit and the country's uncertain and inconsistent attitude to foreign investment have kept India from achieving its growth potential.

Russia's performance since the devaluation in 1998, with the most recent data pegging growth at 9 percent in 2000 and 5 percent in 2001, and the reform policies of the Putin administration are changing both the reality of Russia and investor perceptions about the country. Russia's growth in turn has helped growth in neighboring countries, Ukraine most prominently.


Clearly, the biggest priority for the international community in restoring sustained growth is to make rapid progress in liberalizing trade, which has been the engine of global economic expansion throughout the post-war period.

The Doha round of trade negotiations should thus focus on improvements in agricultural market access and the liberalization of services as the centerpieces of a new agreement to promote development.

This would require trade-offs in a number of areas, including the length of transition periods, offers of technical assistance, environmental concerns, intellectual property considerations and labor standards.

One participant at the World Economic Forum's meeting in New York in late January summed up the situation quite well: ''Unless development is at the center of this round there will be no good conclusion to this round. It will be the 300-year round, not the 36-month round. The solidarity of developing countries, their hard work, their trust, their faith and their hope in the system is evident.''

Indeed, the global trading system should help the developing countries to help themselves -- and doing that is in the interests of all countries.

(c) 2002, World Economic Forum/Global Economic Viewpoint. Distributed by the Los Angeles Times Syndicate International, a division of Tribune Media services.
For immediate release (Distributed 4/16/02)

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